Energy Economics – II
Jeffrey Frankel
Harpel Professor, Harvard University
ADA Summer School, Baku, Azerbaijan
7-9 July , 2010
The Natural Resource Curse


The NRC is often phrased broadly to include not just oil,
but other minerals, & sometime agricultural commodities too.
Seminal references:



Other studies find a negative effect of oil,
in particular, on economic performance:


Auty (1990, 2001, 07, 09)
Sachs & Warner (1995, 2001)
including Kaldor, Karl & Said (2007); Ross (2001);
Sala-i-Martin & Subramanian (2003); and Smith (2004).
Survey: Frankel, “The Natural Resource Curse,”
forthcoming in Export Perils, edited by Brenda Shaffer
(University of Pennsylvania Press).
2
Examples
 Conspicuously high in oil resources
and low in growth:
Venezuela & Gabon.


Conspicuously high in growth
and low in natural resources:
China & other Asian countries.
The overall relationship
on average is slightly negative:
3
Growth falls with oil & mineral exports
4
Are natural resources necessarily bad?
No, of course not.


Oil or mineral wealth need not necessarily
lead to inferior economic or political
development.
Rather, it is a double-edged sword,
with both benefits and dangers.


It can be used for ill as easily as for good.
The priority for any country should be on
identifying ways to sidestep the pitfalls
that have afflicted other mineral producers
in the past, to find the path of success. 5


The goal is to enjoy the success of
 a Chile, not a Bolivia
 a Botswana, not a Congo
 a Norway, not a Nigeria.
The last section of the paper
(Frankel, 2010) explores some of
the institutional innovations that might
help avoid the natural resource curse and
achieve natural resource blessings instead.
6



How could abundance of oil be a curse?
What is the mechanism
for this counter-intuitive relationship?
There are at least 7 lines of argument:
7
7 Possible Natural Resource Curse Channels
1.
2.
3.
4.
5.
Downward price trend
Price volatility
Crowding-out manufacturing
Inhibited development of institutions
Unsustainably rapid depletion
as a result of unenforceable property rights
6.
7.
Proclivity for armed conflict
The Dutch Disease
8
The 7 NRC Channels Elaborated
1.
2.
3.
World commodity price trend
could be downward (Prebisch-Singer);
High volatility of oil prices
could be problematic ;
Natural resources
could be dead-end sectors (Matsuyama):
they may crowd out manufacturing,
1.
2.
which may be the home of
dynamic benefits & spillovers.
“Industrialization” could be
the essence of development.
9
The 7 NRC Channels
continued
4. Countries where physical command
of mineral deposits by the government
or a hereditary elite automatically confers
wealth on the holders may be less likely
to develop the institutions that are
conducive to economic development
(Engerman-Sokoloff …),


e.g., rule of law & decentralization of decision-making,
as compared to countries where moderate taxation
of a thriving market economy is the only way to finance
government.
10
The 7 NRC Channels
continued
5. Non-renewable resources are depleted too fast,
where it is difficult to enforce property rights,
as under frontier conditions.
6. Countries that are endowed with minerals
may have a proclivity for armed conflict,
which is inimical to economic growth.
7. Swings in commodity prices can engender
macroeconomic instability (Dutch Disease),
via the real exchange rate
and government spending.
11
We now go through
the 7 possible NRC channels
(1) The claim of a negative trend
in commodity prices on world
markets was already dealt with:
the data do not suggest a robust
long-term trend, certainly not a
negative one if updated to 2010.
12
(2) Effects of Volatility
Is volatility per se bad for economic growth?
Cyclical shifts of resources back & forth across
sectors may incur needless transaction costs.


A diversified country may indeed be better
than one 100% specialized in oil.

On the other hand, the private sector dislikes risk
as much as the government does,
and will take steps to mitigate it;


thus one must think where the market failure
lies before assuming that a policy of deliberate
diversification is necessarily justified.
13
Effects of volatility, continued


Policy-makers may not be better than individual
private agents at discerning whether
a commodity boom is temporary or not.
But the government cannot
ignore the issue of volatility:


When it comes to exchange rate or fiscal policy,
governments must necessarily make judgments
about the likely permanence of shocks.
More on medium-term cycles
when we get to the Dutch Disease
14
(3) Do natural resources
crowd out manufacturing?

Matsuyama (1992) provided
an influential model formalizing this intuition:
the manufacturing sector is assumed to be
characterized by learning by doing, while the
primary sector (agriculture, in his paper) is not.

The implication:



deliberate policy-induced diversification out of primary
products into manufacturing is justified, and
a permanent commodity boom that crowds out
manufacturing can indeed be harmful.
15
Counterarguments

There is no reason why learning by doing should
occur exclusively in manufacturing tradables.

Nontradable goods can enjoy learning by doing. [1]

The oil sector can as well.


The USA is one example of a country that has enjoyed
big productivity growth in commodity sectors.
Productivity gains have been aided
by American public investment,



since the late 19th century, in such knowledge infrastructure
institutions as the U.S. Geological Survey,
School of Mines, and Land-Grant Colleges. [2]
[1] Torvik (2001).
[2] Wright & Czelusta (2003, p.6, 25; 18-21).
16
Counterarguments, continued



Public investment in knowledge infrastructure
≠ government ownership of the resources
themselves.
In Latin America, e.g., public monopoly ownership
and prohibition on importing foreign expertise or
capital has often stunted development of the
mineral sector, whereas privatization has set it free.
Attempts by governments to force linkages
between the mineral sector and processing
industries have often failed.
17
(4) Institutions
Recent thinking in economic development:


The quality of institutions is the deep
fundamental factor that determines which
countries experience good performance. [1]
It is futile (e.g., for the IMF & World Bank)
to recommend good macroeconomic or
microeconomic policies if the institutional
structure is not there to support them.
[1] Barro (1991) and North (1994).
18
What are weak institutions?

A typical list:







inequality,
corruption,
insecure property rights,
intermittent dictatorship,
ineffective judiciary branch, and
lack of any constraints to prevent elites
& politicians from plundering the country.
“Quality of institutions” has been quantified by World Bank,
Freedom House, Transparency International, and others.



Rodrik, Subramanian & Trebbi (2003) use a rule of law indicator and protection of property rights
(taken from Kaufmann, Kraay & Zoido-Lobaton, 2002).
Acemoglu, Johnson, & Robinson (2001) use a measure of expropriation risk to investors.
Acemoglu, Johnson, Robinson, & Thaicharoen (2003) use the extent of constraints on the executive.
19
Institutions can be endogenous:

the result of economic growth rather than the cause.


The same problem is encountered with other proposed
fundamental determinants of growth,
e.g., openness to trade and freedom from tropical diseases.
Many institutions tend to evolve endogenously,
in response to the level of income,


such as the structure of financial markets,
mechanisms of income redistribution & social safety nets,
tax systems, and intellectual property rules…
20
Addressing endogeneity of
institutions econometrically



Econometricians address the problem of endogeneity
by means of the technique of instrumental variables.
What is a good instrumental variable
for institutions, an exogenous determinant?
Acemoglu, Johnson & Robinson (2001) introduced
the mortality rates of colonial settlers.



The theory is that, out of all the lands that Europeans colonized,
only those where Europeans actually settled were given good
European institutions.
Acemoglu et al figured that initial settler mortality
determined whether Europeans settled in large numbers.[1]
[1] Glaeser, et al, (2004) argue against the settler variable.
Hall & Jones (1999) consider latitude and the speaking of English
or other European languages as proxies for European institutions.
21
Institutions: Econometric findings

The finding is the same, regardless of IV:





Geography and history matter
mainly as determinants of institutions;


“Institutions trump everything else” – Rodrik et al (2002)
Acemoglu et al (2002)
Easterly & Levine (2002)
Hall & Jones (1999)
which is not to say that institutions don’t
also have other important determinants.
In any case, institutions are important.
22
The “rent cycling theory”
as enunciated by Auty



(1990, 2001, 07, 09)
:
Economic growth requires recycling rents
via markets rather than via patronage.
In oil countries the rents elicit
a political contest to capture ownership,
whereas in low-rent countries the government
must motivate people to create wealth,

e.g., by pursuing comparative advantage,
promoting equality, & fostering civil society.
23
A related view by economic historians
Engerman & Sokoloff

Why did industrialization take place in North America,





(1997, 2000, 2002)
not Latin America?
Lands endowed with extractive industries & plantation crops
developed slavery, inequality, dictatorship, and state control,
whereas those climates suited to fishing & small farms
developed institutions of individualism, democracy,
egalitarianism, and capitalism.
When the Industrial Revolution came, the latter areas
were well-suited to make the most of it.
Those that had specialized in extractive industries were not,

because society had come to depend on class structure & authoritarianism,
rather than on individual incentive and decentralized decision-making.
24
The theory is thought to fit Middle Eastern oil exporters
well.
E.g., Iran. Mahdavi (1970), Skocpol (1982, p. 269), and Smith (2007).
Econometric findings that oil
and other “point-source resources
lead to poor institutions





Isham, Woolcock, Pritchett, & Busby
Sala-I-Martin & Subramanian (2003)
Bulte, Damania & Deacon (2005)
Mehlum, Moene & Torvik (2006)
Arezki & Brückner (2009).
(2005)
25
Which comes first,
oil or institutions?


Some question the assumption that oil discoveries
are exogenous and institutions endogenous.
Oil wealth is not necessarily the cause
and institutions the effect,
rather than the other way around.

Norman (2009): the discovery & development of oil
is not purely exogenous, but rather is endogenous
with respect to the efficiency of the economy.
26
The important determinant is whether
the country already has good institutions
at the time that oil is discovered,
in which case it is put to use for the national welfare,
instead of the welfare of an elite, on average.






Mehlum, Moene & Torvik (2006),
Robinson, Torvik & Verdier (2006),
McSherry (2006),
Smith (2007) and
Collier & Goderis (2007).
Luong & Weinthal (2010), in a study of
the 5 oil-producing former Soviet republics:
the choice of ownership structure makes the difference
as to whether oil turns out a blessing rather than a curse.
27
(5) Unsustainably rapid depletion

What happens when a depletable
natural resource is indeed depleted?

This question is important for 3 reasons:

Protection of environmental quality.

A motivation for the strategy of economic diversification.

A motivation for the “Hartwick rule”:


All rents from exhaustible natural resources should be invested
in other assets, so that future generations do not suffer
a diminution in total wealth (natural resource plus reproducible
capital) and therefore in the flow of consumption.
Hartwick (1977) and Solow (1986).
28
Rapid depletion,

Each of these problems would be much less severe
if full assignment of property rights were possible,


thereby giving the owners adequate incentive
to conserve the resource in question.
But often this is not possible,




continued
either physically
or politically.
Especially in a frontier situation.
The difficulty in enforcing property rights over some
non-renewable resources constitutes a category of
natural resource curse of its own.
29
Unenforceable property rights
over depletable resources

Some natural resources do not lend themselves
to property rights, whether the government
wants to apply them or not.



Very different from the theory that the physical possession of pointsource mineral wealth undermines the motivation for the government
to establish a regime of property rights for the rest of the economy.
Overfishing, overgrazing, & over-use of water are
classic examples of the “tragedy of the commons”
that applies to “open access” resources.
Individual fisherman or farmers have no incentive to
restrain themselves, while the fisheries or pastureland
or water aquifers are collectively depleted.
30
Unenforceable property rights,


continued
The difficulty in imposing property rights
is particularly severe
when the resource is
dispersed over a wide
area, as timberland.
But even the classic point-source resource, oil,
can suffer the problem, especially when wells
drilled from different
plots of land hit the same
underground deposit.
31
Unenforceable property rights,

continued
This market failure can invalidate some
standard neoclassical economic theorems
in the case of open access resources.

The resource will be depleted more rapidly than the
optimization of the Hotelling calculation calls for. [1]

The benefits of free trade may be another casualty:
If exports exacerbate
the excess rate of exploitation,
 the country might be better worse off.

[1] E.g., Dasgupta & Heal
(1985).
[2]
[2] Brander & Taylor (1997).
32
(6) War


Where a valuable resource such as oil or diamonds
is there for the taking, factions will likely fight over it.
Oil & minerals are correlated with civil war.

Collier & Hoeffler (2004), Collier (2007),
Fearon & Laitin (2003) and Humphreys (2005).

Chronic conflict in such oil-rich countries as Angola
& Sudan comes to mind.

Civil war is, in turn, very bad
for economic development.
33
(7) The Dutch Disease
and Procyclicality

Developing countries have historically
been prone to procyclicality:




Procyclical capital inflows
Procyclical government spending.
This is particularly true of commodity producers.
The Dutch Disease describes unwanted sideeffects from a strong, but perhaps temporary,
upward swing in the world price of the export
commodity.
34
Procyclicality
Volatility in developing countries

arises both from foreign shocks,


including export commodity price fluctuations,
and from domestic shocks

including macroeconomic & political instability.
35
Procyclicality
Volatility in developing countries
Most developing countries in the 1990s brought
under control the chronic runaway budget deficits,
money creation, & inflation, that they experienced
in the preceding two decades,

but many still showed monetary & fiscal policy
that was procyclical rather than countercyclical:





They tend to be expansionary in booms
and contractionary in recessions,
thereby exacerbating the magnitudes of the swings.
The aim should be to moderate swings

-- the countercyclical pattern that economists, after the Great Depression,
originally hoped discretionary policy would take.
36
Procyclicality in developing countries
Procyclical capital flows
According to theory (“intertemporal optimization”),
countries should borrow during temporary downturns,
to sustain consumption & investment, and should repay or
accumulate net foreign assets during temporary upturns.

In practice, it does not always work this way.
Capital flows are more procyclical than countercyclical. [1]

Theories to explain this involve capital market imperfections,


e.g., asymmetric information or the need for collateral.
[1] Kaminsky, Reinhart, & Vegh (2005); Reinhart & Reinhart (2009); Gavin,
Hausmann, Perotti & Talvi (1996); and Mendoza & Terrones (2008).
37
Procyclicality in developing countries
Procyclical capital flows,
continued
As countries evolve more market-oriented financial
systems, the capital inflows during the boom phase
show up in prices for land & buildings,
and also in prices of financial assets.

Prices of equities & bonds are summary
measures of the extent of speculative
enthusiasm,


often useful for predicting which countries
are vulnerable to crises in the future.
38
Procyclicality in developing countries
Procyclical capital flows, continued

In the commodity & emerging market boom
of 2003-08, net capital flows typically went
to countries with current account surpluses,
especially Asians and commodity producers in
the Middle East & Latin America,


where they showed up in record accumulation
of foreign exchange reserves.
This was in contrast to the two previous
cycles, 1975-1981 and 1990-97, when the
capital flows to developing countries largely
went to finance current account deficits.
39
Procyclicality in developing countries

One interpretation of procyclical capital flows is that
they result from procyclical fiscal policy:




when governments increase spending in booms,
the deficit is financed by borrowing from abroad.
When they are forced to cut spending in downturns,
it is to repay the excessive debt incurred during the upturn.
Another interpretation of procyclical
capital flows to developing countries
is that they pertain especially to oil exporters.
We consider procyclical fiscal policy in the next sub-section,
return to the commodity cycle (Dutch disease) in the one after.
40
Procyclicality in developing countries
The procyclicality of fiscal policy
Many authors have shown that fiscal policy
has tended to be procyclical in developing countries,



especially in comparison with industrialized countries. [1]
A major reason for procyclical public spending:
receipts from taxes or royalties rise in booms.
The government cannot resist the temptation or political
pressure to increase spending proportionately, or more.
[1] Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart, & Vegh
(2004), Talvi & Végh (2005), Alesina, Campante & Tabellini (2008), Mendoza
& Oviedo (2006), Ilzetski & Vegh (2008), Medas & Zakharova (2009) and Gavin
& Perotti (1997).
41
Procyclicality in developing countries
The procyclicality of fiscal policy, continued

Procyclicality is especially pronounced in countries
with natural resources and where income from those
resources tends to dominate the business cycle.


Cuddington (1989) and Sinnott (2009)
An important recent development: some developing
countries, including commodity producers, have been able
to break the historic pattern in the most recent cycle:



Using the boom of 2002-2008 to run budget surplus & build
reserves,
thereby earning the ability to expand fiscally in the 2008-09 crisis.
Chile is the outstanding model.
42
(i) Public investment projects

Two large budget items that account for much
of the increased spending from oil booms:



(i) investment projects and
(ii) the government wage bill.
Regarding the 1st budget item, investment
in infrastructure can have large long-term pay-off
if it is well designed; too often in practice, however,
it takes the form of white elephant projects,
which are stranded without funds for completion or
maintenance, when the oil price goes back down.

Gelb
(1986)
.
43
(ii) Public sector wage bills




Regarding the 2nd budget item,
oil windfalls have often been spent on higher public
sector wages -- Medas & Zakharova (2009) .
They can also go to increasing the number
of workers employed by the government.
Either way, they raise the total public sector wage bill,
which is hard to reverse when oil prices go back down.
Figures 2 & 3 plot the public sector wage bill,
for two oil producers, Iran & Indonesia.

against primary product prices over the preceding 3 years.
44
Figure 2: Iran’s Government Wage Bill Is Influenced
by Oil Prices Over Preceding 3 Years (1974, 1977-1997.)
IRN
Wage Expenditure as % of GDP
16.52
7.4
11.46
59.88
Real Oil Prices lagged by 3 year, in Today's Dollars
Source: Frankel (2005b)
45
Figure 3: Indonesia’s Government Wage Bill Is Influenced
by Oil Prices Over Preceding 3 Years (1974, 1977-1997.)
IND
Wage Expenditure as % of GDP
3.52
1.77
11.46
59.88
Real Oil Prices lagged by 3 year, in Today's Dollars
Source: Frankel (2005b)
46
Public sector wage bills,



continued
There is a clear positive relationship.
That the relationship is strong with a 3-year lag
shows the problem: oil prices may have fallen
over 3 years, but public sector wages cannot
easily be cut nor workers laid off.
Arezki & Ismail (2010) find that current
government spending increases in boom times,
but is downward-sticky.
47
The Dutch Disease:
5 side-effects of a commodity boom

1) A real appreciation in the currency

2) A rise in government spending

3) A rise in nontraded goods prices

4) A resultant shift of resources out of
non-export-commodity traded goods

5) A current account deficit
48
The Dutch Disease: The 5 effects elaborated

1) A real appreciation in the currency



taking the form of nominal currency appreciation
if the exchange rate floats
or the form of money inflows & inflation
if the exchange rate is fixed [1];
2) An increase in government spending

in response to increased availability
of tax receipts or royalties;
[1]


E.g., Edwards (1986). During the boom of 2001-2008, fixed-rate oil-producing
countries where real appreciation came via money inflows & inflation: Saudi Arabia
& the UAE.
Floating-rate oil exporters where real appreciation took the form of nominal
currency appreciation: Kazakhstan, Mexico, Norway, & Russia.
49
The Dutch Disease:
5 side-effects of a commodity boom

3) An increase in nontraded goods prices
(goods & services such as housing that are not internationally
traded),


relative to traded goods
(manufactures & other
internationally traded goods other than the export
commodity).
4) A resultant shift of resources out of
non-export-commodity traded goods

pulled by the more attractive returns in the export
commodity and in non-traded goods.
50
The Dutch Disease: 5 side-effects of a commodity boom



5) A current account deficit (thereby incurring
international debt that may be difficult to
service when the commodity boom ends [2] ).
[2] Manzano & Rigobon (2008): the negative Sachs-Warner effect of
resource dependence on growth rates during 1970-1990 was mediated
through international debt incurred when commodity prices were high.
Arezki & Brückner (2010a): commodity price booms lead to increased
government spending, external debt & default risk in autocracies,


but do not have those effects in democracies.
Arezki & Brückner (2010b): the dichotomy extends also to effects on
sovereign bond spreads paid by autocratic vs, democratic commodity
producers.
51
Summary: Channels of the NRC

(1) Commodity price volatility is high, imposing risk & costs.

(2) Specialization in oil can crowd out the manufacturing sector.

(3) Depletion can be unsustainably rapid,
 especially if property rights are not adequately protected.

(4) Mineral riches can lead to civil war.

(5) Oil endowments can lead to poor institutions,

(6) The Dutch Disease.
such as corruption, inequality, class structure, chronic power
struggles, and absence of rule of law and property rights.
A commodity boom:
=> real currency appreciation and increased government spending,
=> which expand nontraded sector and render uncompetitive noncommodity export sectors such as manufactures
=> debt.
52
The Natural Resource Curse should not
be interpreted as a rule that resourcerich countries are doomed to failure.




The question is what policies to adopt
to improve the chances of prosperity.
Destruction or renunciation of resource endowments,
to avoid dangers such as the corruption of leaders,
will not be one of these policies.
Even if such a drastic action would on average leave
the country better off, which seems unlikely, who
would be the policy-maker to whom one would deliver
such advice?
The paper concludes with ideas for institutions
designed to address aspects of the resource curse
and thereby increase the chance of economic success.
53
54
Addenda:
1) 3 cycles of capital flows
to developing countries
2)Skeptics of the NRC
55
What characteristics have helped emerging
markets resist financial contagion?

High FX reserves and/or floating currency

Low foreign-denominated debt (currency mismatch)




Low short-term debt (maturity mis-match)
High Foreign Direct Investment
Strong initial budget, allowing room to ease.
High export/GDP ratio,


Sachs (1985); Eaton & Gersovitz (1981), Rose (2002); Calvo,
Izquierdo & Talvi (2003); Edwards (2004); Cavallo & Frankel
( 2008).
In the 2008-09 crisis, many of the historical Early
Warning Indicators worked, especially reserves

Frankel & Saravelos (2010)
56
Procyclical capital flows, continued
3 cycles in capital flows to emerging markets

1st developing country lending boom
(“recycling petro dollars”): 1975-1981



2nd lending boom (“emerging markets”): 1990-96



Ended in international debt crisis 1982
7 Lean years (“Lost Decade”): 1982-1989
Ended in East Asia crisis 1997
7 Lean years: 1997-2003
3rd boom
(incl. China & India this time):
2003-2008
57
This time, many countries used the inflows
to build up forex reserves, rather than
to finance Current Account deficits
7.00
6.00
in % of GDP
(Low- and
middle-income
countries)
5.00
4.00
2.00
1.00
2003-07
boom
1991-97 boom
-2.00
-3.00
-4.00
Current
Account
Balance
58
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
19
90
19
89
19
88
19
87
19
86
19
85
19
84
19
83
19
82
-1.00
19
81
0.00
19
80
% of GDP
3.00
Net Capital
Flow
Change in
Reserves
Skeptics argue that commodity exports
are endogenous. [1]


On the one hand, basic trade theory says:
A country may show a high mineral share in exports,
not necessarily because it has a higher endowment of
minerals than others (absolute advantage)
but because it does not have the ability to export
manufactures (comparative advantage).
This could explain negative statistical correlations
between mineral exports and economic development,


invalidating the common inference that minerals are bad for growth.
[1] Maloney
(2002) and
Wright & Czelusta
(2003, 04, 06).
59
Commodity exports are endogenous,


On the other hand, skeptics also have plenty
of examples where successful institutions and
industrialization went hand in hand with rapid
development of mineral resources.
Countries that were able to develop efficiently
their resource endowments as part of
strong economy-wide growth include:




continued.
the USA during its pre-war industrialization period [1],
Venezuela from the 1920s to the 1970s,
Australia since the 1960s, Norway since 1969 oil discoveries,
Chile since adoption of a new mining code in 1983,
Peru since a privatization program in 1992, and
Brazil since the lifting of restrictions on foreign mining
participation in 1995. [2]
[1] David & Wright (1997).
[2] Wright & Czelusta (2003,
pp. 4-7, 12-13, 18-22).
60
Commodity exports are endogenous,

Examples of countries that were equally
well-endowed geologically but that failed to
develop their natural resources efficiently
include:



continued.
Chile and Australia before World War I,
and Venezuela since the 1980s.[3]
[3] Hausmann (2003, p.246):
“Venezuela’s growth collapse took place after 60
years of expansion, fueled by oil. If oil explains slow
growth, what explains the previous fast growth?”
61